The Wealth Curse -- why we are almost always less wealthy than we think we are

Wealth is an expectation about the future. Absent a complete set of futures markets, our expectations won't aggregate up, because our plans for the future are interdependent and almost always mutually inconsistent. Other people aren't planning to do what fulfilment of our own plans requires them to do. Our plans are going to be disappointed, even if nothing exogenous changes.

That was the short version. Here's the medium version:

Some people are planning today to buy a house 10 years in the future. And other people are planning today to sell a house 10 years in the future. But there is no market open today to ensure that the number currently planning to buy a house 10 years in the future equals the number currently planning to sell a house 10 years in the future. Planned future excess demands are almost always non-zero, even in a world of perfectly flexible prices. Our planned future trades are "false trades", at disequilibrium expected future prices. It is impossible for us all to realise our current plans for future trades.

49.99% of the time, planned future demand will exceed planned future supply at the prices people expect, so prices will rise relative to what was expected, even if nothing else changes. Those planning to buy will be disappointed, and those planning to sell will be pleasantly surprised. But since demand exceeds supply, there are more disappointed buyers than pleasantly surprised sellers. On average, people will be disappointed.

49.99% of the time, planned future supply will exceed planned future demand at the prices people expect, so prices will fall relative to what was expected, even if nothing else changes. Those planning to sell will be disappointed, and those planning to buy will be pleasantly surprised. But since supply exceeds demand, there are more disappointed sellers than pleasantly surprised buyers. On average, people will be disappointed.

Our plans for the future are almost always mutually inconsistent, because there is no market open today to make those plans mutually consistent. On average, we will be disappointed. We are almost always less wealthy than we think we are.

{Update. Here's a picture to explain what I mean.

This is exactly like the standard textbook diagram showing the gains from international trade, where the world price happens to exceed the domestic autarky price. Except in this case, the net welfare gain triangle is an illusion, because there are no foreigners who will buy the excess supply at the expected price. But if people think they will be able to buy and sell as much as they want at the expected future price, the total surplus they expect to receive (the sum of producer plus consumer surplus) will exceed the actual total surplus when the price falls to the market-clearing level.]

That was the medium version. Here's the long version.

Scott Sumner has been reflecting on Tyler Cowen's reflections on whether we are/were as wealthy as we think/thought we are/were. I want to bring a idea from Hayek/Keynes/Hicks into play.

Hayek said that the job of markets is to coordinate the plans of individuals -- to make them mutually consistent. And to aggregate the local information held by separate individuals. Keynes said that the fundamental problem is the absence of futures markets where savers could place orders today for goods to be delivered in the future. Hicks introduced the concept of a temporary equilibrium, where markets cleared today based on expectations of future prices.

Rolling Hayek, Keynes and Hicks all together, we get the idea that the absence of futures markets is a problem, because there is nothing to coordinate individuals' current plans for future purchases and sales. Nothing ensures that the quantity of apples people currently plan to buy next year equals the quantity of apples people currently plan to sell next year. We do not live in a Arrow-Debreu world of complete markets, and so people's current plans for the future are almost certainly mutually inconsistent.

What's this got to do with whether we are less wealthy than we think we are? What we think as individuals almost always does not make sense in aggregate, unless there is something like a market to make our individual thoughts mutually consistent. Let me explain.

Assume that the current price of houses is an equilibrium, so quantity demanded equals quantity supplied at the current price. And assume I am the representative agent, who owns his own house outright, and who planning neither to buy or sell houses at the current price. The house price fairy then visits me, and offers to double house prices, halve house prices, or leave house prices the same. My choice.

Standard micro theory says I will take the fairy up on her offer. If house prices double, or halve, I can't be made worse off, since I can always just stick with my current house if I want to. But I will probably choose to do even better than that. If prices double, I could sell my house and downsize, if I prefer. If prices halve, I could sell my house and buy a bigger better one, if I prefer. Go read my old post, for clarification.

OK, now I've got three idea in play: whether we are as wealthy as we think we are; Hayek/Keynes/Hicks on futures markets; and the house price fairy. Time to bring all three together.

The fairy who offers to double or halve current house prices is a myth. Prices can't just double or halve by themselves; there has to be some shift in demand or supply to make them double or halve. A doubling of current house prices, given current demand and supply curves, would cause an excess supply of houses, bringing the price straight back down again. "Never reason from a price change", as Scott Sumner puts it. But a fairy who offers to double or halve expected future house prices is not so mythical. We won't find out she can't do it until the future. And when the future arrives, and we find out that the fairy was wrong, and didn't do what she said she would do, the representative agent is worse off.

To put it in terms of Hayek/Keynes/Hicks, the current price of houses is coordinating the current plans of current buyers and sellers. The current price is pinned down at whatever level coordinates current demand and supply. But, absent a market where we can buy or sell houses now for delivery 10 years in the future, there is nothing to pin down current expectations of house prices 10 years in the future, and nothing to ensure that current plans to buy and sell houses 10 years in the future are mutually consistent.

Even if everybody has the same expectation about future prices. And even if there is no unexpected exogenous shock to change our plans, those plans will almost always be mutually inconsistent. A mythical central planner, who interviewed everyone alive today, would be able to tell us that our expectations of the future and planned purchases and sales in the future do not make sense in aggregate. What we think as individuals, and what we would think if our thoughts were surveyed and the aggregate survey results published, aren't always the same thing. "What we think" -- whether it is is about our wealth, or about anything -- usually doesn't make sense, at any aggregate level.

It's a bit like the Winner's Curse, where the winner of the auction will tend to be the bidder who has the most optimistic beliefs about the value of the good being auctioned. And like the Winner's Curse, it is subject to this critique: "If bidders knew about the Winner's Curse, they would take it into account when bidding, and bid lower, and the Winner's Curse would disappear". If people knew about the Wealth Curse I am describing here, or had experienced its disappointment on average even if they did not understand its source, they would revise their wealth expectations downward. "Things usually turn out worse than people expect, so I had better be a bit pessimistic".

OK. Let's revise it. Half the time, people's plans for the future are less mutually inconsistent than average, so the wealth curse is less than expected. And the other half the time, people's plans for the future are more mutually inconsistent than average, so the wealth curse is more than expected. If the world unfolds roughly as we expect it to, we should be pleasantly surprised by the unexpectedly small size of the wealth curse. If the world unfolds very differently from what we expected, we should be unpleasantly surprised by the unexpectedly large size of the wealth curse.

Start in equilibrium. Full-blown Arrow-Debreu equilibrium, where both current and planned future excess demands are zero. Then knock out the futures markets. Then the future house price fairy convinces everyone that future house prices will double, relative to what they had previously expected. Current house prices rise, of course (as we move to the new Hicksian temporary equilibrium), but the rise in current prices has no wealth effect, since buyers=sellers and the gain to current sellers equals the loss to current buyers (don't argue this point, it's off-topic, but read this.) But the rise in expected future house prices does increase wealth, because lots of people are planning to sell in the future and almost nobody is planning to buy (since expected future prices are too high by assumption). And when the future arrives, and the price falls back to the Arrow-Debreu equilibrium, wealth falls back down again. It turns out we weren't as wealthy as we thought we were. It would be exactly the same if the fairy halved future house prices, and there were lots of people planning to buy and almost nobody planning to sell.

This post is not really about houses. It's about planned future excess demands or supplies of any good. Non-zero planned future excess demands create illusory wealth. It's probably related to Austrian Business Cycle Theory, though I have never properly understood ABCT.

I've been implicitly assuming a barter economy. I reckon things would be weirder still in a monetary exchange economy.

Comments

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Merriam-Webster's Collegiate Dictionary says "Wealth 1. obs: weal, welfare 2:abundance of valuable material possessions or resources.3: abundant supply : Profusion." etc. Nothing implies future expectations. that hurts this piece. Regarding the probability of expectations, they're always wrong and always have been. If they weren't, dime novels would have meant mass stupidity, the ability tor read would have been killed by movies, then television. Comic Books would have led to crime and sexual perversion. Video games would have filled homes for mentally disturbed. The Internet would have meant people couldn't read your article. Viewing with alarm is a multi-billion dollar business today. Don't buy it. It's not worth it.

Ken: the people who wrote Merriam Webster don't really understand what wealth is. The value of any asset is the expected present value of its future returns.

Yes, expectations are almost always wrong. That's not an interesting claim. To say that incorrect but unbiased individuals' expectations of prices will create a bias in a particular direction in expected wealth at the aggregate level is an interesting claim.

As usually happens, you covered my intended comment toward the end of the post. So I have little to say except "well done." Maybe this is off topic, but is there any meaningful difference between saying we've misjudged our housing wealth because:

1. The housing fairy
2. The Fed is about to cut M in half, and drive real GDP much lower--reducing housing demand. And we don't know it yet.
3. The interest deduction on mortgages is about to be repealed in the US, and we don't know it yet.

Thanks Scott. Your return to blogging is having positive spillover effects. (A "multiplier effect", if you like.) Helps get my mind out of the Summer doldrums, where I thought I had run out of things to say.

"...you covered my intended comment toward the end of the post."

My guess is you were planning to say something like my "If bidders knew about the Winner's Curse, they would take it into account when bidding, and bid lower, and the Winner's Curse would disappear"? Funny that I don't hear this critique of the Winner's Curse very much. Or maybe I just miss hearing it.

2 and 3 are exogenous shocks, and we can always be wrong about exogenous shocks, but in either direction. I'm trying to say that there is some sort of systemic systematic endogenous bias in our aggregate expectations about wealth (unless of course people take that bias into account). My hypothesis (applied to the US housing market) does assume that a lot more people than normal who owned houses during the boom were planning to sell in future. And that only the normal number of people (or fewer than normal) were planning to buy in future. I think that's plausible.

An ugly little theory slain by a beautiful obvious fact: we are not, historically speaking, poorer than we thought. We have spent the last century and a half continually being surprised by our wealth. What is needed to make the theory interesting is a feature which would explain why the past few years are an anomaly, but your argument would apply during the long periods when it is known to have been false.

A technical note: once you are working in an incomplete market you cannot assume that prospective buyers and sellers can be represented by an agent with the same characteristics. There is nothing to prevent representative buyers and sellers from using different probability measures resulting in different expectations of future prices. Thus it is possible for everyone to be pleasantly surprised despite your observations about supply and demand excesses (sellers expected future prices would be lower than the realized prices, buyers expected higher, everybody celebrates.)

I don't think this observation could be used to answer my previous objection, but ... you never know.

Phil: "We have spent the last century and a half continually being surprised by our wealth."

Is that a fact? ("where's my flying car, dude?")

In the last few years, more people have (I conjecture) been more wrong about expected future (relative) prices than they normally have been.

Yes, if buyers and sellers have systematically different expectations about future prices, that can cause mistakes about wealth. But the effect I'm talking about here works even if everybody has the same expectation.

Your answer is consistent with my intuition, but the more I think about it, the less the distinction holds up. Any false forecast is a false forecast. If I think future housing prices stay high, and they don't, I made a false forecast. If I forecast the Fed won't allow deflation, and it does, I made a false forecast (of course people like Cassel said in 1920 that the post-WWI gold standard made deflation inevitable.) If I forecast no asteroid hits Boston, and it does, that's a false forecast. I don't see any categorical difference between the house fairy and the other cases, in each case something happens that I didn't expect. But I admit that from a common sense perspective it does seem quite different.

The winner's curse problem is so blindingly obvious that I can't even understand why anyone would talk about the curse. It makes my hair hurt. It's like when finance profs come up with market anomalies, instead of doing what they should be doing (studying whether the class of mutual funds structured to take advantage of market anomalies outperforms those that aren't structured that way.) Data mining is such an obvious problem, I can't believe that elite professors get published with market anomaly studies. I guess I'm just a bitter old reactionary.

Scott: compare:
1. Every farmer expects he will have a good harvest.
2. Every farmer expects he will win the annual farmers' poker tournament.

If everybody thinks that future house prices will be high, and each plans to get rich by selling at that high future price, the situation is more like 2 than 1. They can't all be right. Their priors don't add up, collectively. But, unless each knows every other person's future plans, they can't know that their priors don't add up.

(I am pleased to see that Wikipedia notes the flaw in Winner's Curse.)

Nick, I know I say this to you often, but it definately bears repeating: You are one of the sharpest thinkers I have come across in my life. I wish I could have had you as one of my economics professors

Hicks introduced the concept of a temporary equilibrium, where markets cleared today based on expectations of future prices.

Is this correct? I imagine that the cite for this is Value and Capital (1939). I understood Keynes to be using this framework in GT (1936), where he assumed short term expectations to be fulfilled, LT ones to be g-d knows what, and the result a temporary equilibrium, for good or bad.

JCE and Scott: thanks for those words. I feel a bit of a fraud though. All I teach (all I feel competent to teach nowadays) is intro economics, intermediate macro for non-economics majors, and macro for grad students in Public Admin.

Marcel: Value and Capital was what I had in mind. Yes, the GT is sort of temporary equilibrium, but didn't have the microfoundations normally associated with general equilibrium theory. Like almost any discovery in economics, you can find another economist who sort of did it earlier. Hayek, for example, can be seen as having been doing temporary equilibrium analysis. The concept "temporary equilibrium" is associated with Hicks. I will defer to serious historians of thought.

This post is not really about houses. It's about planned future excess demands or supplies of any good. Non-zero planned future excess demands create illusory wealth. It's probably related to Austrian Business Cycle Theory, though I have never properly understood ABCT.

At a minimum, this problem says something about why the natural rate of interest is unstable, and possibly explain how the ABCT and the EMH can coexist. The deus ex machina in the ABCT has always been why banks, in aggregate, distort the market-rate of interest and repeatedly err, and the broader economy is then repeatedly fooled by the distortion in the price signal.

Nick, I very much enjoyed this post. In a post on Friday, I also discussed Hicksian temporary equilibrium in the context of aggregate demand shocks and sticky prices, but your discussion was really insightful. Of course the problem becomes even more complicated because we all know that we haven't any definite idea of what our planned purchases or sales are more than a few weeks into the future. Our plans are constantly evolving and not mainly because prices turn out to be different from what we expect them to be.

I think the relation of all this is to Austrian capital theory is that by making the time structure of production explicit, Austrian theorists were more sensitive to the need for coordination between plans through time rather than at a single point in time. This led Hayek to formulate a concept of intertemporal equilibrium that I am sure influenced Hicks (who was Hayek's student for a while at LSE) in conceptualizing temporary equilibrium in Value and Capital. Interestingly in The Pure Theory of Capital, Hayek criticizes temporary equilibrium for reasons that I could not understand. I once asked Hayek why he was critical of temporary equilibrium and he couldn't really explain why he took issue with it, acknowledging that perhaps he hadn't understood what Hicks was doing. That was perhaps 30 or 40 years after the fact, so one has to allow for some fading in his memory.

Jon: "At a minimum, this problem says something about why the natural rate of interest is unstable, and possibly explain how the ABCT and the EMH can coexist."

I tend to agree with that, though I wish I could understand it more clearly.

"The deus ex machina in the ABCT has always been why banks, in aggregate, distort the market-rate of interest and repeatedly err, and the broader economy is then repeatedly fooled by the distortion in the price signal."

I also tend to agree. In defence of ABCT though, savers and investors are planning to buy/sell future goods, and so their real interest rates depend on future prices. So even if there's a complete set of forward nominal interest rates, the relevant real rates are not revealed by the market. (And TIPS just gives an aggregate real rate, not the specific real rates that individuals care about, and that real rate may be a false price in any case.) I wish I understood this better.

David: thanks!

If intertemporal plans are inconsistent, it won't just be beliefs about wealth that are wrong. People will be making all sorts of mistakes in their current decisions. "Malinvestment", the Austrians would say.

Nick, You are welcome. Actually I think that "malivestment" in Austrian terminology may have a more restricted meaning than simply investment undertaken under mistaken expectations of the future. I think, and I may be wrong about this, that "malinvestment" is restricted to overly round-about investments that are induced by a market interest rate held below the "natural" level by monetary expansion by the banking system. Investment undertaken under incorrect expectations unrelated to the level of interest rates would be classified as routine entrepreneurial error. If I have a chance I will see if I can find Mises's definition somewhere.